Time for a Change: Tax-Free Reorganizations

Life is fluid and constantly changing, and in the global business environment, things can change even faster. Corporations and their shareholders are in a constant state of flux and adaptation as they respond to the multitude of internal and external pressures of the modern-day global economy. Businesses have to change if they want to survive, and whether it be to increase efficiencies, consolidate, improve the bottom line, or completely change ownership, a reorganization is one method a company can use to address the need for change.

Section 368 of the Internal Revenue Code (the “Code”) gives corporate taxpayers the ability to reorganize their businesses tax-free (or partially tax-free) when structured under its provisions.

In the context of an acquisition or sale of a business, reorganizations help both buyers and sellers achieve their desired business objectives while allowing the seller to defer some or all of the gain arising from the sale of corporate stock or assets. Without §368, the sale would be taxable immediately.

The main premise of acquisitive §368 transactions is that the acquiring corporation (the “acquiror”) uses its own stock as the main form of consideration when purchasing the assets or stock of the selling corporation (the “target”). To the extent the target received no cash, gain will not be recognized, instead, it will be deferred. The gain can be deferred because the shareholders of the target still only hold stock after the transaction is complete, and under §358 and §362 the sellers take their historical basis in the stock they receive. As such, the sellers are in the same position both before and after the sale (when only stock is exchanged). If there is no cash received, no taxable gain will be triggered. Therefore, the gain is deferred until the shareholder sells their stock for cash.

Transaction Requirements

There are five types of acquisitive tax-free reorganizations. To qualify for any of them, the Code outlines requirements that must be present in the transaction structure:

There must be a Continuity of Ownership Interest;

There must be a Continuity of Business Enterprise;

The transaction must have a Bona Fide Business Purpose and not be for the purpose of tax avoidance;

The transaction must not fail under the Step Transaction Doctrine; and

The transaction must take place pursuant to a Plan of Reorganization

If even one of the requirements above is not met, the transaction will fail to qualify for tax-free treatment under §368

Acquisitive Reorganization Types

As mentioned above, §368 identifies five types of acquisitive reorganizations.

§368(a)(1)(A): Type “A” Reorganization, Statutory Merger

A type “A” reorganization is the most flexible type of reorganization. In an “A” reorganization one corporation acquires the assets and assumes the liabilities of another corporation. The target corporation transfers its assets and liabilities in exchange for the acquiring company’s stock. The target corporation goes out of existence in the merger or consolidation transaction under state law. At a minimum, at least 40% of the proceeds of the sale must come in the form of stock in the acquiring corporation; the remaining 60% can be in cash. If cash is paid to the target’s shareholders, then some gain may be recognized.

§368(a)(2)(D): Forward Triangular Merger

A forward triangular merger is a version of a type “A” reorganization, and shares many of the same characteristics and classifications. However, instead of the target’s assets and liabilities merging directly going into the acquiror as in a straight type “A” merger, the acquiring company forms a new subsidiary for the target to merge into, with the target company dissolving. One advantage over a straight type “A” merger is that all of the target’s liabilities now belong to the subsidiary, and the parent company is protected from risk.

In a type “C” reorganization, substantially all of the target corporation’s assets are exchanged for voting stock in the acquiring corporation. The target company dissolves and the acquiring company takes a carryover basis in the target’s assets. The mechanics and the ending organizational structure of a type “C” reorganization closely resembles an “A” reorganization. However, a “C” reorganization does not offer same levels flexibility, as cash cannot exceed 20% of the consideration (an “A” can have up to 60%). The main advantage of a “C” reorganization is the acquiror can chose to exclude certain liabilities, and does not have to assume all the liabilities of the target.

§368(a)(1)(B): Type “B” Reorganization, Exchange of Stock

In a type “B” reorganization, the target corporation’s shareholders exchange the target corporation’s stock for voting stock of the acquiring corporation. The target then becomes the subsidiary of the acquiror. This type of reorganization provides very limited flexibility, in that no cash can be used as consideration. If even $1 of cash is used, the transaction becomes fully taxable. With the previously discussed asset based reorganizations, certain assets such as contracts and licenses are terminated, as assets are transferred to a new corporation. An advantage to a stock based “B” reorganization, is that assets such as contracts and licenses remain inside the target, and are not terminated.

§368(a)(2)(E): Reverse Triangular Merger

A reverse triangular merger is a hybrid reorganization that has similarities between a type “A” and “B”. In a reverse triangular merger, the acquiror creates a new wholly owned subsidiary for the target to merge into; the target merges into the subsidiary, with the target surviving. The target corporation then exchanges its stock for voting stock in the acquiring parent company. The resulting structure is the same as a “B” reorganization with the target now being a subsidiary of the acquiring parent company. A reverse triangular merger allows the same benefit of a “B” reorganization of keeping non-transferrable asset (contracts, licenses, etc.) intact, and allows the target shareholders to receive cash. In a reverse triangular merger, up to 20% of the consideration paid to the target shareholders can be cash.

For many businesses, the decision to sell, buy, or reorganize is a rare occurrence, but if and when the opportunity presents itself, careful consideration should be given. The rules associated with these types of transactions are detailed, complex, and often require strict adherence to tax laws. Each party to the transaction brings a different set of facts and circumstances to the table, and each party has business goals they wish to achieve. Different requirements, such as the amount of cash needed or the ability to transfer assets will dictate the form the transactions will take. With careful planning, it may be possible to achieve the goals of both parties in a buy/sell transaction.

If you would like more information on acquisitive or other forms or reorganization, let us know, and if you a thinking about buying or selling a business, please consult your Peterson Sullivan representative to find out if one of the transaction structures discussed above is right for you.

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